A ques­tion of equi­lib­rium for in­vestors

Hawke's Bay Today - - Business - A Canny View

With global debt now passed its 2008 level — US$250 tril­lion at last count — could we be head­ing for GFCII: The se­quel?”

“New Zealand’s NZX 50 share in­dex has been caught in the volatil­ity as in­vestor con­fi­dence swings be­tween bullish­ness, based on US-fun­da­men­tals, and fears about emerg­ing mar­kets and a US-China trade war.”

“Sell­ers were out in force on the mar­ket to­day af­ter neg­a­tive news on the econ­omy.”

There’s been a lot of noise in me­dia fi­nance re­ports in the past month. But have you ever won­dered that if there are so many sell­ers out there, who is buy­ing?

The no­tion that in down days sell­ers out­num­ber buy­ers doesn’t make sense. What the news­cast­ers should say is that prices ad­justed lower be­cause would-be buy­ers weren’t pre­pared to pay the for­mer price.

What hap­pens in such a case is ei­ther the would-be sell­ers sit on their shares or prices ad­just lower un­til sup­ply and de­mand come into bal­ance. This is when trans­ac­tions oc­cur and is de­scribed by econ­o­mists as “equi­lib­rium”.

But equi­lib­rium isn’t a per­ma­nent state. That’s be­cause new in­for­ma­tion is com­ing into the mar­ket­place con­tin­u­ally, forc­ing would-be sell­ers and would-be buy­ers to con­stantly ad­just their ex­pec­ta­tions.

That new in­for­ma­tion might be com­pany-spe­cific news on earn­ings. It might be news that has im­pli­ca­tions for spe­cific in­dus­tries — like a spike in oil prices. Or it might be an eco­nomic devel­op­ment that af­fects the en­tire mar­ket, like an un­ex­pected change in in­ter­est rates.

Given this con­stant flux in the flow of news and in­for­ma­tion and the chang­ing ex­pec­ta­tions of par­tic­i­pants, in­di­vid­ual se­cu­ri­ties and the mar­ket it­self are said to be al­ways mov­ing to­ward equi­lib­rium.

When se­cu­rity prices are fall­ing, it can be re­as­sur­ing to re­mem­ber that sup­ply and de­mand must come into bal­ance for trades to oc­cur. Buy­ers even­tu­ally see value in the mar­ket and will in­vest if the prices are low enough.

Try­ing to time these in­flec­tion points with any re­li­a­bil­ity is tough. That’s be­cause prices at any point re­flect the com­bined ex­pec­ta­tions of all mar­ket par­tic­i­pants based on cur­rent pub­licly avail­able in­for­ma­tion. If the in­for­ma­tion changes, prices may change. But that re­quires an abil­ity to both fore­cast news and to an­tic­i­pate cor­rectly how mar­kets will re­spond to that news.

Here’s an ex­am­ple from out­side the share­mar­ket to ex­plain how mar­ket equi­lib­rium works: Back in early 2011, a cy­clone dev­as­tated about 75 per cent of the ba­nana crop in the Aus­tralian state of Queens­land, which pro­duces more than 90 per cent of the na­tional crop.

With sup­ply short, re­tail prices for the fruit soared from around $3 to nearly $15 a kilo within months.

Farm­ers who had al­ready har­vested their crops sold at sig­nif­i­cant mar­gins. Many con­sumers stopped buy­ing bananas al­to­gether be­cause the prices were just too high for their tastes.

But then prices stopped ris­ing as con­sumers pulled away from the mar­ket. And, as full sup­plies slowly re­turned, prices grad­u­ally fell to end the year back down where they be­gan.

Sim­i­larly, se­cu­rity prices rise and fall con­tin­u­ously based on a mul­ti­plic­ity of in­flu­ences, in­clud­ing sup­ply and de­mand, news about the in­di­vid­ual com­pany and its in­dus­try, de­vel­op­ments in the econ­omy or even gen­eral ex­pec­ta­tions about the share­mar­ket.

Try­ing to un­tan­gle all these in­flu­ences and sec­ond-guess the prices which re­flect the com­bined wis­dom of would-be buy­ers and sell­ers is a near im­pos­si­ble ask.

An al­ter­na­tive ap­proach is to start by ac­cept­ing that prices are fair and point to the col­lec­tive ex­pec­ta­tions of mar­ket par­tic­i­pants. While in­for­ma­tion fre­quently changes, this is quickly built into prices. Com­pe­ti­tion among buy­ers and sell­ers is such that it’s ex­tremely hard to out­guess the mar­ket.

The sec­ond step is to see that fairly priced se­cu­ri­ties can have dif­fer­ent ex­pected re­turns. And we can use mar­ket prices and se­cu­rity char­ac­ter­is­tics to iden­tify those se­cu­ri­ties that of­fer higher ex­pected re­turns.

The third step is to build highly di­ver­si­fied port­fo­lios around these broad driv­ers of re­turn, while im­ple­ment­ing ef­fi­ciently and keep­ing costs low.

The fi­nal step is stay­ing dis­ci­plined and re­bal­anc­ing your port­fo­lio oc­ca­sion­ally to stay within your cho­sen risk pa­ram­e­ters or to ad­just for changes in cir­cum­stances.

Ul­ti­mately, the mar­ket is like a giant weigh­ing ma­chine. All those in­flu­ences men­tioned above are con­stantly be­ing as­sessed by mil­lions of par­tic­i­pants. And prices con­stantly ad­just based on those col­lec­tive ex­pec­ta­tions.

The pre­mi­ums we ex­pect from in­vest­ing are not there ev­ery day, ev­ery month, ev­ery week or even ev­ery year. But the longer we stay in­vested, the more likely we are to cap­ture them. And, in the mean­time, we can im­prove the re­li­a­bil­ity of out­comes by di­ver­si­fy­ing.

So, rest as­sured, even when prices are fall­ing there are still peo­ple buy­ing. The mar­ket is do­ing its job and the re­wards will be there if you re­main dis­ci­plined and di­ver­si­fied.

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